Cryptoasset Exchange Traded Notes for Professional Investors: an FCA Update

Recently, the FCA updated its position on cryptoasset exchange-traded notes (ETNs). This update is important for professional investors who deal with these instruments, but it may also have implications on the broader institutional influence that crypto is having. This article will explain what ETNs are, summarise the FCA’s latest update and discuss its implications.

Background on Cryptoasset Exchange Traded Notes 

Cryptoasset exchange-traded notes (ETNs) are debt securities that track the performance of cryptocurrencies. Unlike exchange-traded funds (ETFs), which own the underlying assets, ETNs are unsecured debt obligations issued by financial institutions. This means they are subject to the credit risk of the issuer.

ETNs offer a way for investors to gain exposure to cryptocurrency markets without directly holding the assets. This is handy for a few reasons, but even more so for crypto where ownership can come at its own risks, such as lost or hacked keys.

They are traded on exchanges, making them accessible and providing liquidity. ETNs can be a useful tool for professional investors looking to diversify portfolios or hedge against market volatility.

Cryptoasset ETNs are different from other crypto-related investments. They provide a regulated environment, which can offer more security compared to direct investments in cryptocurrencies. Even in the instance of offloading one’s own ownership responsibility to an exchange or hot wallet, there come even more risks. This avoids those risks.

However, they also carry risks of their own of course, including the potential for issuer default, as well as market fluctuations.

Is This Similar to the SEC’s ETF Law Change?

This is a very different news story from the US Securities and Exchange Commission (SEC) approving crypto Exchange Traded Funds (ETFs)---besides the fact that it’s another step towards institutional acknowledgement of crypto’s legitimacy. 

cETNs are debt instruments issued by financial institutions, they’re not about the funds in one’s portfolio that can be traded in a way to gain crypto exposure, like ETFs. cETNs do not give the investors ownership of the underlying asset (crypto). Not to mention that the crypto ETFs approved by the SEC are open to all investors (both retail and professional), whereas the cETNs in the UK will only be available to professional investors. Instead of market and asset risk, they instead pose a credit risk.

An Example of a Crypto cETN in Action

An example of what we may expect from the new law change is a UK investment company buying a cETN that is linked to Bitcoin. This means that the investment company is lending the bank money. The investment firm does not own any Bitcoin directly but will receive returns (on this loan) that are tied to Bitcoin’s immediate price changes. So, the “interest” of the loan repayment is related to how well Bitcoin is performing.

The value of the cETN—which can be sold to another investment firm—of course, depends on the financial health of the issuing bank, which is responsible for repaying their debt and is now tied to the price of Bitcoin. In theory, if the issuing bank defaults or goes bankrupt then the firm may lose its investment.

FCA's Updated Position on Cryptoasset ETNs 

The FCA’s recent update focuses on the regulation of cryptoasset ETNs for professional investors specifically. The key points of this update mostly focus on stricter guidelines and enhanced oversight. The FCA aims to ensure that these financial products are used responsibly and that investors are, ultimately, protected.

One significant change is the requirement for more detailed disclosures about the risks associated with ETNs. Issuers must provide clear and concise information, ensuring that investors understand the potential downsides. This includes market volatility, the credit risk of the issuer, and the complex nature of the underlying assets.

The FCA also emphasises the need for robust risk management practices. Financial institutions issuing ETNs must have systems in place to monitor and manage risks effectively. This includes regular stress testing and maintaining adequate capital reserves.

Furthermore, the FCA has introduced measures to enhance transparency. Issuers are now required to report more frequently on their activities and the performance of their ETNs. This aims to provide investors with timely information, helping them make better-informed decisions.

The update also references the marketing of cryptoassets, which we are familiar with regarding the marketing of consumer-focused cryptoasset projects. The FCA insists that marketing materials must be fair, clear, and not misleading. This is to prevent exaggerated claims about potential returns and to ensure that investors have a realistic understanding of what they are buying.

Overall, the FCA’s updated position reflects its commitment to protecting investors, but also its willingness to work with cryptocurrency within well-established financial markets. This balanced approach is in line with recent FCA updates over the past couple of years.

Rationale Behind the FCA's Update 

The FCA updated its rules on cryptoasset ETNs to address a few different concerns. These concerns were around market developments, risks to investors, and, of course, the need for better regulation. It’s always worth understanding the FCA’s thought process and position on these changes because it can help foresee future changes.

First and foremost, the crypto market has grown rapidly in recent years—not only in the number of projects and coins but the total market capitalisation of crypto. This growth brings new risks to new eyes, not least because cryptoassets are known for their price volatility. Sudden price changes can lead to significant losses, and in the context of ETNs, can increase the financial burden on issuers to meet repayment obligations. 

The FCA wants to ensure that investors understand these risks. By requiring clearer risk disclosures, the FCA can try to better protect investors from unexpected losses.

Second, the FCA is concerned about the credit risk of ETNs as the value of ETNs depends on the issuer's creditworthiness. If an issuer defaults, investors could lose their money—and when in conjunction with crypto volatility, these risks could be cumulatively high. 

The FCA now requires issuers to manage this risk better by having systems to check and control risks and keep enough capital to cover potential losses. And, they essentially want to ensure that only suitable investors buy ETNs. These products can be complex and risky, particularly with such innovative, technical, and fast-changing underlying assets. The FCA's rules limit ETNs to professional investors who understand the risks involved. This restriction helps protect less experienced investors from potential losses.

Implications for Professional Investors 

The FCA’s update on cryptoasset ETNs has far-reaching implications. These changes not only influence investment strategies but also impact the broader crypto market and its perception.

In general, the update could enhance the legitimacy of cryptoassets. By setting even more clear regulatory standards (added onto their recent changes), the FCA helps integrate cryptoasset ETNs into the traditional financial system. This regulatory backing can increase trust among investors, potentially boosting the market value of underlying assets like Bitcoin itself. 

For example, the rumours and news of the SEC’s regulatory update to crypto ETFs would impact the price of Bitcoin itself, because ultimately the price stems from sentiment and speculation.

When a respected regulatory body like the FCA recognises and regulates cryptoasset ETNs, it signals a degree of legitimacy that can attract more institutional investors to the crypto market. This can also be a positive feedback loop if the price of these coins stabilises more due to institutional backing—and thus, creates further appetite for more backing (and regulation).

It’s also important to consider that professional investors now have more opportunities to diversify their portfolios. Cryptoasset ETNs offer exposure to the volatile yet high-growth crypto market without the need to directly hold the underlying assets. This diversification can help investors balance risk and reward. Plus, ETNs are traded on traditional exchanges and provide liquidity and ease of access compared to direct crypto investments.

ETNs also present a safer investment option compared to direct crypto investments. With ETNs, investors do not need to manage private keys, which eliminates the risk of being hacked or misplacing keys. The regulatory protections and disclosures required by the FCA ensure that investors have access to important information about the risks and performance of ETNs. This contrasts with the largely unregulated nature of direct crypto investments, where market manipulation and fraud remain concerns.

However, the crypto market’s infancy and the inherent volatility of cryptoassets continue to pose risks. While ETNs offer a more regulated investment vehicle, the underlying cryptoassets remain subject to dramatic price swings and large-scale scandals. Investors must consider this volatility when including ETNs in their portfolios. The regulatory framework around ETNs is robust, but the broader crypto market still lacks comprehensive regulation, which can affect ETN performance indirectly. It’s an interesting moment as retail investors have had a greater appetite for crypto than professional investors—but now that door is open, with stronger regulatory protection, many eyes will be watching to see how many step through said door.

Furthermore, the reiteration of the FCA's rules on transparency and risk management certainly improves the overall market infrastructure. Issuers must maintain adequate capital reserves and conduct regular stress tests. These measures help ensure that ETNs remain stable and reliable, even in volatile market conditions. For investors, this means that the risks associated with ETNs are more controlled and predictable compared to direct crypto investments.

Comparison With Global Regulatory Stances 

The FCA’s updated rules on cryptoasset ETNs reflect a cautious but proactive approach. Comparing this stance with global regulators provides a few different regulatory perspectives.

The U.S. Securities and Exchange Commission has taken quite a strict approach to cryptoassets in general—much to the dismay of some enthusiasts. As discussed, the SEC has not approved any cryptoasset ETNs for public trading, which means fewer options for professional investors compared to the UK (despite ETFs now being available).

In contrast, the European Securities and Markets Authority (ESMA) has a balanced approach. ESMA allows cryptoasset ETNs but emphasises strong investor protection. ESMA’s guidelines are fairly similar to the FCA’s updated rules. They require clear risk disclosures, robust risk management and honest marketing. 

Japan’s Financial Services Agency (FSA) also regulates cryptoassets but has taken a more progressive stance. The FSA allows a range of cryptoasset products, including ETNs, and with strict rules to ensure investor safety. Japan’s focus is on promoting technological innovation, which may be driven by their historical economic challenges. This approach encourages growth in the crypto market and is getting attention from overseas markets.

The Australian Securities and Investments Commission (ASIC) has a mixed approach, as they permit cryptoasset ETNs but impose strict disclosure. ASIC’s regulations align closely with the FCA’s recent updates and highlight global coordination.

Switzerland’s Financial Market Supervisory Authority (FINMA) offers one of the most crypto-friendly environments. FINMA allows a wide range of cryptoasset products, with ETNs being one of many. The Swiss approach is progressive, but not lax, as they enforce strict anti-money laundering (AML) and know-your-customer (KYC) regulations.

As we can see, global regulators vary in their approaches to cryptoasset ETNs—but not by much. The SEC’s strict stance contrasts with the more balanced approaches of ESMA and ASIC. For the most part, there is alignment among most major regulators around the world, which is important given the global nature of crypto.

Future Developments 

The future of cryptoasset ETNs in the UK and globally looks promising, but it’s now clear just how much they depend on regulatory developments. 

In the UK, the FCA's updated rules set a clear framework for the issuance and management of ETNs, and this framework will continue to become more sophisticated and watertight. As the market grows, we can expect more issuers to enter the space, offering a wider range of ETNs, and likely other categories of products too. 

Ultimately, the FCA need to ensure investors can maximise their returns (within reasonable risk) else they will lose out to overseas markets. Having said that, the FCA doesn’t want to lose its strong reputation for robustness by being the first-mover on crypto developments, in case they go too far, too soon. 

Globally, we are seeing regulators use other countries as testing pools, in which everybody has eyes on one another. The FCA and the SEC are leaders, but in this instance, they’re not first-movers. As more countries develop their regulatory frameworks, the market for cryptoasset ETNs is likely to expand. 

Conclusion 

The FCA's updated position on cryptoasset ETNs enhances investor protection while supporting market growth. By understanding these changes, professional investors can step into the world of crypto without the ownership risks that come with it, all whilst having one eye on the future of regulatory updates. If you have any questions for our team, get in touch today.